Question of the Day

What is the total number of months during the Ford, Carter, Reagan and Bush I administrations, plus the first term of Clinton, when the unemployment rate was lower than today?

Answer:  1

(March 1989, when it was 5.0%)

Come on discouraged workers, get out there and start looking!

Say goodbye to the “discouraged workers”

For the past few years I’ve been suggesting that the labor force participation rate is not going to bounce back.  Commenters have insisted that the workers were just “discouraged”, and that they’d come back in and start looking for jobs when the labor market got somewhat better.

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Today the unemployment rate fell to 5.1%.  If that’s not the natural rate, it’s pretty close. Close enough so that if you really wanted a job you should at least be looking by now.  And yet the Labor force participation rate is 62.6%, the lowest level since the 1970s. No, I’m afraid the discouraged workers are gone for good.  Indeed the Fed wants to tighten now to prevent the job market from overheating!

I watched CNBC this morning during the jobs report, and the commentary was pretty funny.  They didn’t seem to think a quarter point was a big deal, and suggested that it might mean about 10% off the Dow.  But 10% corrections happen quite often, so it’s no big deal!  They were genuinely puzzled by why the stock market thought it was a big deal.  “Just a quarter point.”  One Tea Party type bragged that he’s been for a rate hike for 4 years.  I’ve noticed recently that people don’t seem at all embarrassed when their previous policy recommendations turn out to be totally wrong in retrospect.  Even worse, they don’t seem aware of the fact that they were wrong.  Monetary policy commentary is just free floating atavistic urges, completely untethered from any sort of model of policymaking, or economic data.

Over at Bloomberg there’s a new editorial today calling for the ECB to abandon its 2% inflation target and replace it with . . . with . . . with . . . I get to the end of the article and there’s just nothing.  Just get rid of the 2% inflation target.  That’s all. It would be like the captain instructing the pilot “don’t steer east by northeast.”

PS.  In my previous post I erroneously stated that the Neo-Fisherians believe in short run monetary superneutrality.  David Andolfatto pointed out that this claim is not correct.  Mea culpa.  Fortunately it did not affect any of the substantive points I was trying to make.  (I think what confused me is that short run superneutrality will also get you to Neo-Fisherism.  But it’s not a necessary condition, as I should have realized.)

A “powerful argument” for market monetarism?

Unfortunately market monetarism is still a fringe movement, even less popular than other heterodox theories like ABCT. So I have to constantly act like that nerdy guy who barges into a party he wasn’t invited to.  Noah Smith recently quoted John Cochrane on the problems with traditional Keynesianism and traditional monetarism:

The conventional way of reading this graph is that inflation is unstable, and so needs the Fed to actively adjust rates…When inflation declines a bit, the Fed drives the funds rate down to push inflation back up…When inflation rises a bit, the Fed similarly quickly raises the funds rate.

That view represents the conventional doctrine, that an interest rate peg is unstable, and will lead quickly to either hyperinflation (Milton Friedman’s famous 1968 analysis) or to a deflationary “spiral” or “vortex.”…

But in 2008, interest rates hit zero…The conventional view predicted that the broom will topple. Traditional Keynesians warned that a deflationary “spiral” or “vortex” would break out. Traditional monetarists looked at QE, and warned hyperinflation would break out…

The amazing thing about the last 7 years in the US and Europe — and 20 in Japan — is that nothing happened! After the recession ended, inflation continued its gently downward trend.

This is monetary economics Michelson–Morley moment. We set off what were supposed to be atomic bombs — reserves rose from $50 billion to $3,000 billion, the crucial stabilizer of interest rate movements was stuck, and nothing happened.  

Then Noah Smith adds the following comment:

This is a powerful argument, and I think that those who sneer at Neo-Fisherism don’t take it seriously enough.

That said, there are some serious caveats.

And before Noah explains his views, this is where I barge in, like a student eagerly waving his hand up to be called on.

Let’s slow down and figure out what John Cochrane is glossing over.  He was right that an interest rate peg was supposed to lead to hyperinflation or a deflationary vortex.  But Friedman did not believe that this applied at the zero bound.  Rather he thought that when nominal rates were positive an interest rate peg makes the quantity of money endogenous, and that’s where the problems come in.  (Indeed Friedman once argued for zero nominal interest rates on “optimal quantity of money” grounds.) Now in fairness to John, he’s right that traditional monetarists overestimated the impact of base increases at the zero bound, or more precisely didn’t adequately account for the distinction between temporary and permanent injections (which Krugman modeled in the now-famous 1998 paper.)  So it’s fair to criticize the traditional monetarists, even if they didn’t expect price level indeterminacy at the zero bound.

And it’s also fair to criticize the Keynesians for their flawed Phillips Curve approach, which predicted more deflation than we actually got (even more so in countries like Britain.)

But unless I’m mistaken the market monetarists got this exactly right.  Let’s take it in steps:

1.  We accept the distinction between temporary and permanent currency injections.  So like Krugman we said there’d be no high inflation.  He relied more on Phillips Curve thinking and IS-LM, we relied more on TIPS spreads (the market part of market monetarism.)

2.  But unlike many Keynesians, we thought QE could be effective at the zero bound.  This would also prevent deflation from occurring.  Which it did.  Further support for the model occurred after the BOJ adopted a more expansionary policy, and deflation ended.  And of course markets (stock and forex) in the US, Europe and Japan clearly believe monetary policy matters at the zero bound. In my view that means a University of Chicago guy like John Cochrane should be required by law to believe the same thing.

Noah Smith then criticizes the neo-Fisherites:

Our basic supply-and-demand intuition says that demand curves slope down and supply curves slope up. Dump a lot of a commodity on the market, and its price will fall. Start buying up a commodity, and its price will rise.

Neo-Fisherianism goes against this intuition. Suppose the Fed lowers interest rates. Abstracting from banks, reserves, etc., it does this by printing money and using that money to buy bonds from people in the private sector. That increase in demand for bonds makes the price of bonds go up, and since interest rates are inversely related to bond prices, it makes interest rates go down.

Now, you can write down a model in which this doesn’t happen – for example, a model in which Fed money-printing-and-bond-buying stimulates the economy so much that interest rates end up rising instead of falling. But in practice, it looks like the Fed has total control over interest rates (at least, the Federal Funds Rate; let’s put aside the question of heterogeneous interest rates).

So when the Fed lowers interest rates, it prints money in order to do so. But in a Neo-Fisherian world, that makes inflation fall – in other words, it makes money more valuable. That’s worth repeating: In a Neo-Fisherian world, dumping a ton of new money on the market makes money a more valuable commodity.

That is weird! That totally goes against our Econ 101 intuition! How does dumping money on the market make money more valuable??

I think this is exactly backwards, but nonetheless Noah ends up in the right place. How he ends up being correct despite flawed reasoning is an exercise worth spending some time on.

Let’s start with the supply and demand model, which Noah cites in support of his advocacy of what’s usually called the “liquidity effect.”  The supply and demand model assumes perfect competition and price flexibility.  But in that sort of world money is superneutral, even in the short run.  Do you see the problem?  Neo-Fisherism is basically a model that claims money is superneutral, even in the short run.  In this model a lower rate on money growth immediately causes lower inflation.  And since prices are flexible in a S&D model there is no liquidity effect. Thus monetary policy doesn’t impact real rates, and hence slower money growth leads to both lower inflation and lower nominal interest rates.

In contrast, Noah assumes the lower interest rates are caused by “printing money.” But what makes him think that? Because it’s true?  OK, it probably is true in some cases, but it’s not true if NeoFisherism is true.  So it’s a weird assumption to use when criticizing NeoFisherism.

There are all sorts of problems with trying to apply S&D in the way that Smith tries to.  If you want to apply the S&D model to bonds, you need to account for the fact that money is itself the medium of account.  So changes in the supply of money change its value, and hence change the supply and demand for bonds.  That’s the story of the 1960s and 1970s.  Printing lots of money made bond yields rise.  (It’s also the problem with “Cantillon effect” claims that the Fed buying bonds helps bondholders.)  Long-term T-bond holders were devastated by the Great Inflation. So no, there is no S&D presumption that more money should lead to lower nominal interest rates, even if the new money is used to buy bonds (as it was in the 1960s and 1970s).

Take a look at money growth (the base) and short-term nominal interest rates from 1948 to 1982.

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Unfortunately it’s a big mess, because monetary policy is partly endogenous.  But if you look closely you can see some support for Neo-Fisherism, but also why people like Noah and I are a bit skeptical.

The long run trend looks Neo-Fisherian.  But it was a struggle to even find that much correlation.  Other periods of American history are far messier.  For instance, there was virtually no expected inflation under the gold standard.  And recently base growth has soared at the zero bound.  So the Great Inflation is the period where it seems to work best.  The Fed gradually printed money at a faster and faster rate.  Inflation rose higher and higher, and so did nominal interest rates.

But if you look closely you’ll also see the opposite.  Right before the 1960, 1970, 1980 and 1982 recessions, nominal rates spiked upwards and yet money growth seemed to slow.  In those cases a tight money policy raised nominal rates, and this lowered inflation, perhaps with a slight lag due to sticky prices.

In fairness to the Neo-Fisherites, if I’d shown you the correlation between inflation and nominal rates it would have been even stronger.  For instance, higher inflation leads to higher velocity.  So when money growth rose during the Great Inflation, so did velocity.  This meant that inflation rose by even more than money growth, and the high inflation helps explain why nominal interest rates were so much higher than money growth during 1979-81—velocity was rising as there was a flight from the dollar.

Lower interest rates won’t cause low inflation, but a tight money policy that leads to low inflation will also lead to low nominal interest rates much more quickly than most Keynesians assume.  In other words the income and Fisher effects begin to dominate the liquidity effect more quickly than you might assume, and one can construct plausible thought experiments where Neo-Fisherism is even true in the short run.  But in the world we currently live in, a September rate increase by the Fed will lead to lower inflation than not raising rates in September.

Cochrane and Williamson don’t have to convince me, they have to convince Wall Street.  One nanosecond after Wall Street is convinced, I’m on board.

I also have recent posts on the interest sensitivity of the economy, and rational expectations, over at Econlog.

HT:  Gordon

The long run is now

I recently criticized the view that the Fed might want to consider raising interest rates because a long period of low rates could lead to financial imbalances, such as “reaching for yield.”  I actually have several problems with this view, but focused mostly on the implicit assumption that tighter money would lead to higher interest rates.  That’s not true over the sort of time frame that people are worried about.

Tyler Cowen linked to the post and offered a few comments:

Scott Sumner dissents on reach for yield.  I don’t think easier money will boost the American economy right now.  So I think you just get a loanable funds effect and then possibly a reach for yield.

A few reactions:

1.  I have a rather unconventional view on the question of policy lags, which Tyler is probably referring to in his “right now” remark.  I believe that monetary policy affects RGDP almost immediately, or at least within a few weeks.  This is based on three interrelated claims, which may or may not be true:

a.  Monetary policy immediately affects expected future NGDP growth.  That can be defended either as a definition (I define the stance of policy as expected NGDP growth) or if you prefer it can be defended on EMH/Ratex grounds.  If it affected growth expectations with a lag, then there would be lots of $100 bills on the sidewalk.  I don’t see many.

b.  Changes in expected future NGDP have an almost immediate impact on current NGDP growth.  I can’t prove this, and it’s the weakest link in the chain.  But I strongly believe it to be true.  Someone should do a study correlating changes in expected future NGDP (perhaps 4 quarters forward, consensus forecast) with changes in current NGDP.  I expect a strong correlation.  Thus during periods where the expected future NGDP falls sharply, such as the second half of 2008, current NGDP also falls sharply.

c.  Changes in current NGDP are highly correlated with changes in current RGDP. This is one of those “duh” observations, at least for anyone who pays attention to the data.

Most people believe in long and variable lags, because they associate “monetary policy” with changes in interest rates.  If the Fed created and subsidized trading in a NGDP prediction market, I believe we would quickly discover that my view of policy lags is correct, and the consensus view is wrong.  But even if I were wrong, wouldn’t it be useful to pin down this sort of stylized fact? You’d think so, but my profession seems surprisingly uninterested in these sorts of things.

2.  The loanable funds effect is exactly why I think I’m right.  Faster growth would lead to more demand for loanable funds, and thus higher interest rates.  I wonder if Tyler is referring to the “liquidity effect”, the tendency for monetary injections to lower interest rates in the short run.  If so, I don’t think this effect lasts long enough to justify distorting Fed policy with tight money in order to stop people from “reaching for yield.”

3.  I don’t like the term “reach for yield.”  When the interest rate falls, it’s rational for people to value any given future cash flow at a higher level.  So if rates fall for reasons unrelated to corporate profits or returns on apartments, then stock and real estate prices should rise.  That’s markets working the way they are supposed to.  I believe low interest rates are the new normal of the 21st century (partly but not entirely for Cowenesque “Great Stagnation” reasons), so I’m not at all concerned by higher asset prices.

4.  Tyler is on record predicting a very bad recession in China, and also for being open to arguments that the Fed might want to consider raising interest rates this year.  Each is an eminently reasonable and defensible view.  But surely they can’t both be true?  If China is going into a very bad recession, I can’t even imagine a scenario where the Fed raises rates and then a year later looks back and says, “Yup, we’re sure glad we raised rates.”  Stocks plunged earlier today on just a tiny, tiny piece of bad manufacturing news out of China.  How tiny? Notice that the same low PMI occurred three other times in the past 4 years, without RGDP growth ever falling below 7%.

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What would that index look like if Chinese RGDP growth was actually about to turn negative?  What would US stocks look like?

5.  I strongly agree with Lars Christensen’s post, which suggests that the Chinese are making a mistake by trying to prevent the yuan from falling.  I also agree with those who claim that recent events show the Chinese leadership to be less competent in economic affairs than many had imagined.  This is a consequence of development; the problems become trickier than when you are just cleaning up after the Maoist disaster.  They don’t seem to be any better at monetary policy than we are.

6.  Off topic, I probably erred in saying Trump has no chance.  That’s my personal view, but maybe I’m just an old timer who is out of touch with changes in America. After all, Berlusconi was elected three times in Italy.  I saw Trump as just another example of a rabble-rouser like George Wallace or Patrick Buchanan, who rose up and then faded.  That’s still my gut level view, but commenter “John” points out that Trump does have a non-zero chance in prediction markets, and I do claim to be an EMH guy.  More importantly, even though Trump and Sanders are unlikely to even be nominated, I see their rise as bad news for American politics.  I could even see their limited success hurting the stock market slightly, as the prospect for sensible economic and immigration reforms seems ever more distant.  Historically, markets do worse in times when the political situation is adrift.  And at the moment China, the US and Europe all seem to be a long way from the almost effortless competence of the Reagan/Clinton era.

PS.  Japan 2014, Canada 2015.  Another fake “recession” call.  Read about it at Econlog.

Skeptical of the China data skeptics

The problem with answering comments is that one has to swat down one conspiracy theory after.  One recurring theme is that the China GDP data is fake. People breathlessly report obscure data on electricity production or rail shipments. I don’t doubt that the Chinese data is flawed, but there’s no reason to assume it’s not broadly correct.  You need to look at the big picture, and with China I mean really big.

1.  The quarter-to-quarter data is strangely smooth (although that’s partly an artifact of their use of year over year, rather than quarterly data.)  But over the business cycle RGDP growth varies as much as in the US, indeed even more.

2.  People forget that until recently China had 10% trend growth, so when it goes from 14% to 7%, that’s a big slowdown.  People also forget that some sectors of the Chinese economy are probably growing smoothly.  Health care, college education, subways rides (which are constrained by capacity), etc.  So if the overall RGDP growth rate slows from 14% to 7%, and some sectors are growing smoothly at 10%, then the cyclical sectors are slowing extremely rapidly.  And the cyclical sectors are also the commodity intensive sectors.  You could easily see lots of industry data that seems inconsistent with a 7% RGDP growth rate, during a cyclical slowdown.

3.  People sometimes argue that the trend rate has not been 10% in recent decades, but more like 7% or 8%.  The problem with these conspiracy theories is that China’s just too big and open to world trade to cook the books in that way. That’s because over the period since 1980, that kind of cheating would lead to China’s RGDP being overstated by a factor of 2 or 3.  China would now be far poorer than claimed.  (Having said that, trend growth is slowing, and will probably be 5% to 6% over the next decade.)

4.  The World Bank has China’s RGDP/person in PPP terms at 72.7% of Mexico, which seems about right to me (I’ve visited many areas of both countries.) By comparison, India’s at 33% of Mexico.  Does anyone think China’s even close to India?  Yes, China has poor rural areas, probably more than Mexico.  But some rural areas (like the highly populated Yangtze delta) are much richer than you’d think.

5.  These theories would also require cheating on all the sectoral data.  But trade data is two sided, and other countries also report soaring Chinese exports since 1980.  Chinese consumers buy 20 million cars per year, vs. 1 million in Mexico. And yet the poorer China has only 11 or 12 times Mexico’s population. India, with almost as many people as China, has a market of less than 3 million cars/year. That’s just cars, but take any appliance you wish and China looks at least as rich as the data shows, at least in terms of purchasing power.

6.  Maybe the auto figures are also faked.  Maybe VW and GM and all the other western car companies making cars in China are in on the conspiracy.  Maybe the Australian mining firms that claim to sell a God-awful amount of iron ore to China are also faking the data, as are the auto parts suppliers.  Maybe China’s not the world’s biggest exporter, not the world’s biggest carbon emitter.

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7.  Or maybe China really is 72.7% as rich as Mexico. Look at Chinese wages.  They only passed the Philippines in 2000, and are now more than 4 times higher.  They passed Indonesia in 2003, and are now twice as high.  And those two countries have been growing at about 5%/year.  Indeed I find that graph hard to believe, given how much richer Malaysia is than China:

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(OK, the previous picture is Beijing, so here’s a pic from Guangxi, one of China’s poorest regions):

Screen Shot 2015-08-30 at 10.17.38 AMAnd the next picture is from China’s absolutely poorest province, Guizhou.

(The article I found this picture in says this province is becoming a center of “big data.”  Would that happen in Chiapas?):Screen Shot 2015-08-30 at 10.38.04 AM